The Low-Interest-Rate Blues

It’s fair to blame the Fed for what it didn’t do.

One of the most insidious developments in the economic crisis has been the low-interest-rate environment. Short-term interest rates have been stuck near 0 percent for four years, while long-term interest rates have declined to historically low levels. These low interest rates have created numerous problems for the U.S. economy. Retirees and other individuals living on fixed incomes have been hit hard by the sharp decline in their interest earnings. Life-insurance companies and pension funds are finding it difficult to meet their obligations as the low interest rates drive down the return on their mandated investments in long-term debt securities. Banks and other financial firms face narrower profit margins between their borrowing and lending interest rates, making it costly for them to provide the credit needed for a robust recovery. An important question, then, is, Why are interest rates so low?

The most obvious answer is that the monetary policy of the Federal Reserve is keeping them low. Many observers point to the Fed’s large-scale asset-purchase programs as the reason for the low interest rates. Others point to the Fed’s forward guidance on interest rates that says the target federal-funds rate will remain in the exceptionally low 0–0.25 percent range for some time. These observations have led some to conclude that the Fed is not only creating a drag on the economy with its low-interest-rate policies, but is also making it easier for Congress and the president to avoid tough budget choices and enabling large government deficits by reducing the Treasury Department’s financing costs.

This understanding, however, runs up against three inconvenient facts. First, the Fed has not been dominating the Treasury market. At the end of 2012, the Fed held only 15 percent of all marketable Treasury securities, roughly the same share it has held over the past decade. This means that the largest-ever run-up of public debt was financed mostly by individual investors, their financial intermediaries, and foreigners. Second, the Fed’s forward guidance on interest rates is itself shaped by the Fed’s forecast of the economy. The Fed, then, is not independently shaping the future path of interest rates, but is responding to what it thinks will happen to the economy in the future. Finally, long-term interest rates on safe government debt across the world have fallen: Very similar sustained declines in government-bond yields have occurred over the past four years in the United States, the United Kingdom, Germany, and Japan, as the graph below shows. It is far easier to explain these declines as a function of a weak global economy than to attribute them to an overactive, all-powerful Fed.

Several months ago, the Fed stated its desire to lower long-term interest rates, and it has consequently increased its purchases of long-term Treasuries. Empirical studies, however, suggest that the effect of these purchases is nowhere near powerful enough to explain the persistent decline of long-term interest rates. The ten-year Treasury, for example, has gone from about 5.25 percent in 2007 to just over 2 percent today. If these purchases were truly adding a large monetary stimulus, we would expect to see long-term interest rates rise, not fall, from the resulting higher expected inflation and, to the extent the stimulus works, an improved economic outlook.

The proximate reason, then, for the low-interest-rate environment is that the ongoing weak economy has stirred investors’ appetite for safe and liquid assets. Households, for example, continue to hold an inordinately high share of money-like assets, including Treasuries, in their portfolio of assets, as the graph below shows.

Households’ high share of safe assets should not be surprising given the spate of bad economic developments over the past five years: the Great Recession, the euro-zone crisis, concerns about a China slowdown, the debt-ceiling dispute of 2011, and the more recent fiscal-cliff talks. The immediate effect of these developments was to create uncertainty about future economic growth and raise the demand for money-like assets. This elevated broad money demand not only has kept interest rates low, but also has prevented a robust recovery from taking hold.

While this absolves the Fed of direct responsibility for the low-interest-rate environment, it does not absolve it for its indirect influence. Through its control of the monetary base, the Fed can shape expectations of the future path of current-dollar or nominal spending. Thus, for every spike in broad money demand, the Fed could have responded in a systematic manner to prevent the spike from depressing both spending and interest rates. In other words, the Fed could have adopted a monetary-policy rule that would have committed it to maintaining stable growth of total-dollar spending no matter what happened to money demand. A promise from the Fed to do “whatever it takes” to maintain stable nominal-spending growth would have done much by itself to prevent the money-demand spikes from emerging at all. Why hold a greater number of safe, liquid assets if you believe the Fed will keep the dollar value of the economy stable?

There is a name for this rule-based approach to monetary policy: nominal-GDP targeting. It would keep nominal spending stable while also adding more long-run certainty to the nominal incomes of households and firms. Additionally, with this approach, the Fed’s balance sheet would not be blown up by ad hoc large-scale asset-purchase programs. The Fed’s failure to adopt something like a nominal-GDP target in 2008 meant that the central bank would not be able to adequately respond to the subsequent money-demand shocks that arose over the next four years. That is, the Fed’s inaction allowed the pernicious low-interest-rate environment to develop. So while the Fed did not directly cause the low-interest-rate environment, our central bank allowed it and all of its associated problems to emerge. For that it should be blamed.